Financial Warrants Offer Outsized Gains

 | Jun 03, 2013 | 12:30 PM EDT
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Despite the fact that the easy gains for owning bank stocks have come and gone, the runway still looks long for the financial industry today. (I remember 2009, 2010 and 2011 and being in the minority camp touting names like Bank of America (BAC) and Goldman Sachs (GS).

The improvement in the U.S. economy, albeit not smooth and widespread, is excellent news for financial stocks but one that won't manifest for another couple of years. The continued pickup in economic activity -- growth in home and auto purchases -- represents loans that are of much higher quality than the class of 2007 and 2008. The quality of today's loans will begin to show up each and every quarter on the income statement of the banks.  

Despite the shift in analyst perception (analyst Meredith Whitney last year called BofA one of the most compelling opportunities around), most seem to have forgotten about bank warrants. They are a little side effect of the financial crisis that could potentially be a huge investing home run

Warrants are essentially call options on stocks with the one major difference being time: warrants can have a life of many years will the longest standard call options have a life of 24-to-30 months. When Uncle Sam invested in the preferred securities of many of the largest financial institutions, the banks also issued warrants to the U.S. Treasury as an added kicker.

The Treasury, not really interested in becoming a common equity holder, sold these warrants to investors over the past couple of years. Investors stand to reap enormous gains from them during the next few years.

Consider one of my favorites, the Bank of America class A warrants (BAC.WTA) which entitle the holder to buy shares of BofA at $13.30 and don't expire until January 2019. The warrants trade for $6 today while BofA trades for just under $14. The warrant price today consists primarily of time value -- investors are paying over $5 per warrant for the option to buy BofA over the next five and one half years. The value here is if BofA really starts going over the next several years. At $27 a share, the warrants would be at least $14, plus any additional time value of money. At $30 a share, the warrants would be worth at least $17, plus any additional time premium. Perhaps just as valuable, if not more so, is the added kicker that the strike price of the warrants will adjust downward if BofA increases its dividend payment. If in three years BofA is trading for $27 and is paying a dividend of 50 cents a share, the warrant upside is amplified.

In addition to BofA, AIG (AIG) has an attractive warrant. AIG common was a recent purchase of noted value investor Seth Klarman. The AIG warrants (AIG.WT) have a strike price of $45 and don't expire until January 2021. AIG shares currently trade for $45 while the warrants trade for just over $18. AIG currently has a book value per share of over $67. Historically, AIG has traded at 1.2 to 1.3 book or over $80 per share. At that price, the warrants would be over $40. The key here is that warrants give you a window of over seven years for this to happen.

Warren Buffett's favorite bank Wells Fargo (WFC) also has warrants with the same fine print as the BofA warrants with respect to dividends. The warrants have a strike price of $34.01 and expire in October 2018. They trade under the symbol (WFC.WT) and are currently priced at $14. Wells Fargo shares trade for just under $41.  

Despite acting like options, I would not treat these warrants as such. Their greatest potential will likely come from holding them for at least a couple of years. The underlying stocks are large blue chip companies that are not longer very volatile so the warrants aren't ripe for a quick 50% return as you would find with some options. But possibility of triple digit gains in 2-3 years is just as appealing.

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